Sentance to ponder [sic]

Andrew Sentance (yes, sorry about that) writes in the Sunday Times about inflation and in particular, why it is stubbornly high in the UK compared to the rest of the world.

Taking out the VAT rise, strong oil price and fall in the pound, he notes that:

It appears that instead of pushing down significantly on cost and price increases, the impact of spare capacity on domestic inflation has been muted.

Assuming this is correct - and we must remember that there is an economic recovery under way, so we'd expect some inflation - we are left with an important question. Why is there so little spare capacity in the UK?

It's important not just in order to keep inflation down. More deeply, it matters because real growth in the economy only happens when more productive capacity comes into use. If there is no spare capacity, we can't have growth until we invest in new production, and that takes time.

Sentance points out that:

Unemployment has risen to a lower level than...in the early 1980s and early 1990s — it is at 8% of the labour force rather than 10%. The latest CBI survey shows 62% of manufacturers reporting spare capacity, in line with the average for the decade before the crisis. This evidence is hard to square with the drop in GDP figures...

The 62% figure may hide something - it doesn't tell us how much spare capacity each manufacturer has. If, instead of falling across the board, sales held up for the highest-quality companies and fell disproportionately for the rest, there might now be more capacity unused than in the past. Unfortunately, it would be of the kind that is less likely to come back into use as the economy grows. Successful companies are more likely to invest in building new high-quality capacity than to find clever ways to quickly use the excess that sits in their competitors' factories.

Similarly with the labour force - which is a more important component of economic capacity in the UK economy than the capital stock. Unemployment has risen a few percentage points, but perhaps the people who lost their jobs were mostly the marginal employees - who are unlikely to contribute much to productive growth in the recovery. There is, unfortunately, a large number of people in the UK without many marketable skills.

One of the most important meanings of the economists' beloved word "flexibility" in the economy is its ability to bring marginal resources into useful operation. Marginal labour and capital will only be employed if there are creative people ready to figure out how to make that happen.

It's a cliche to bemoan the lack of two things in the British economy: management skills and an educated workforce - but I fear that lack is exactly what leads to the OBR's new estimate of spare capacity in the UK: a frighteningly tiny 2%.